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Shorting the pound

Shorting the pound

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There have been reports that some hedge-fund bosses made huge profits by betting that the pound would fall. They did it by shorting the market. How does it work?

When Kwasi Kwarteng announced some of the biggest tax cuts in living memory and huge levels of public borrowing to fund them, the markets took the view that it was a reckless gamble by the government.

“The British pound touches a record low against the dollar as investors make known their displeasure over London’s big spending plans. Even reassurance from the Bank of England hasn’t helped.”

DW News

The pound also collapsed against the euro, which is bad news for people in the UK because it imports more than it exports – and most of those things come from the Eurozone and the US.

A weaker pound against those currencies makes goods and services more expensive, potentially pushing up an already high inflation rate.

But it’s good news for some people in the market who run hedge funds, like Crispin Odey, who Kwasi Kwarteng worked for before becoming an MP. 

Here he is after the Brexit referendum:

“There’s an Italian expression, “Il mattino ha l’oro in bocca,” the morning has gold in its mouth and never has one felt so much, that idea as this morning”

Crispin Odey speaking to the BBC

Hedge fund managers trade by either going long – buying a stock or currency with a view to selling it at a higher price – or by going short.

Crispin Odey has been shorting the pound and UK government bonds for some time. And it’s paid off.

Last week his flagship hedge fund was up by about 145 per cent this year.

Speaking to the Financial Times, Crispin Odey denied that he had a trading advantage because the chancellor used to work for him.

Instead, he said, “All I can do is catch the wind now and again.”

So how did he, and others, catch the wind?

***

Most short selling happens with company shares, but as the past few days have shown, it also happens with currencies.

This is how it works…

Instead of buying pounds in dollars a trader borrows them and then sells them on the open market before the value of the pound against the dollar drops.

In this case they would’ve sold just before or immediately after the mini-budget, but crucially before people realised the implications of what had been announced.

Once the price of the pound dropped they would’ve bought the same number of pounds they’d borrowed and then sold.

And finally, they would’ve returned the currency to the lender they bought it from originally.

The profit they made is the difference between what they made for selling it and the price they paid for buying it back.

Essentially it’s a bet, but a well-informed one.

***

People like Crispin Odey are now betting that the pound will fall even further to reach parity – the same price – as the dollar.

Before Kwasi Kwarteng’s announcement, a pound cost $1.13.

Afterwards, it fell as low as one dollar point zero three five.

The difference sounds small, but it can translate into big gains for investors – who trade enormous sums of money – and can have serious implications for the rest of us.

Now though, the value of the pound is back to where it was before the mini budget, because after more than a week of volatility in his own party and on the markets, Kwasi Kwarteng has u-turned on one of his most symbolic measures – the abolition of the top rate of income tax.

“We felt that the 45p issue, the 45p rate was drowning out a strong package of intervention on energy, a strong package of intervention on tax cuts for people generally. And we decided not to proceed with getting rid of the 45p rate.”

Chancellor Kwasi Kwarteng speaking to BBC Breakfast

It was that measure that caught markets off guard, because this was a surprise change to the tax system that they hadn’t seen coming and they wondered how the government could afford it along with everything else. 

By scrapping the plan the chancellor has reassured them.

But the damage may have been done.

***

The Bank of England estimates that, on average, between 60 and 90 per cent of a fall in the pound’s value – feeds into higher import prices.

And that’s why the central bank had to announce a massive market intervention, and why it’s expected to raise interest rates again: to stabilise the pound and control inflation.

But that will lead to higher borrowing costs for households with mortgages and credit card debt, and companies that want to borrow money to invest.

So Kwasi Kwarteng’s next challenge is to explain how he’ll pay for the help the government is giving people with their energy bills and the other tax cuts he announced.

If it’s just through borrowing it could trigger another collapse in the pound, which is why some are concerned about another round of cuts to public spending instead.

This episode was written by Paul Caruana Galizia and mixed by Imy Harper.



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